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Trickle-Down Deficits

This week, President Bush released his proposed federal budget, which, as expected, signaled a return to deficit spending. Between a sluggish economy and increased spending on defense and “homeland security” the surplus has evaporated. But Washington is not the only government facing an economic crunch. In fact, state governments across the nation are swimming in red ink, and unlike the federal government, most states have laws that require budgets to be balanced. The National Association of State Budget Officers (NASBO) projects state shortfalls to total $40 billion for 2002.

Throughout the economic boom of the 1990s, state budgets grew substantially, as income growth funneled increasing amounts of revenue into state coffers. Average annual state budget increases were more than 7 percent for 1999 and 2000, and the average increase was over 8 percent in 2001. The recession and the attack of September 11 have left the economy languid, which means that revenues in most states are not as high as once forecast. Despite the drop in economic activity, only 6 states have reduced outlays for 2002; 44 states will see an increase, with the average increase at 2.8 percent (NASBO). While smaller than recent budget increases, the continued push for more spending demonstrates the challenge states face when attempting to correct imbalances between spending and revenues.

In addressing budgetary problems, states have various options, including tax hikes, spending cuts, and accessing “rainy day” funds to make up budgetary shortfalls. There are also a number of accounting and budget gimmicks that can be used to hide any gaps in the budget. While spending cuts, revenues, and rainy day funds are all legitimate avenues to explore, the varying strategies will have different impacts on long-run economic growth within the state. Budget gimmickry, on the other hand, is a weak attempt to maintain the status quo in hopes that an economic recovery will correct any budgetary imbalances without making serious choices about state spending priorities.

Inevitably, many states fall back on budget and accounting gimmicks as a first line of defense against red ink. One common tactic is to delay expenditures until the next fiscal year, which does nothing to address the shortfall. Or, as the Center on Budget and Policy Priorities notes, New Hampshire’s senate simply voted to increase revenue estimates by $60 million to balance the budget. Funds from the tobacco settlement, purportedly intended to address smoking concerns, have also been a valuable source for cash-strapped states. Tennessee, Iowa, and Wisconsin have all tapped into the tobacco settlement. Budget gimmicks avoid important decisions about resource allocation and purposely obfuscate the budgetary process to the detriment of taxpayers. We expect higher standards of private corporations we entrust with our money and we should expect no less from the government. Rather than gimmicks and accounting tricks, states should promote transparency and accuracy in their budgets.

Can States Tax Themselves into Prosperity?

Expanding the revenue base is an option that many governors—Republicans and Democrats alike—are pursuing. North Carolina is leading the charge with a hefty $650 million tax increase. While not as bold, many other states are also searching for ways to boost revenues. Most of these efforts are focused on corporate taxes; new excise taxes on such items as alcohol, tobacco, gas, and gambling; new fees for government services; and, new state revenues generated by introducing lotteries.

However, tax hikes can adversely affect economic growth, particularly in a recession. As consumers and businesses struggle to make ends meet, an increasing tax burden reduces economic activity in the private sector in order to fund a larger state government. Studies have demonstrated that dollars spent in the private sector have a greater impact on the economy than dollars spent by the government. Professor Richard Vedder, in a study for the Joint Economic Committee, found that a 1 percent increase in government expenditures as a percentage of GDP led to a reduction of the Dow Jones Industrial Average falls by 500 to 1,000 points.

In addition, it must be remembered that a cyclical economic slowdown is a temporary phenomenon. If, as most analysts suggest, the economy recovers by the second quarter of 2002, a return to economic growth will boost state revenues without increasing taxes. Most taxes under consideration at the state level are permanent in nature, which means that even after the recovery, taxes will be higher than necessary because permanent tax hikes have been instituted to address a temporary phenomenon.

Virtually all economists agree that taxes are counter-cyclical, which means that raising taxes in a recession will hamper the recovery. States seeking to address shortfalls through higher taxes risk long term damage to the economy without addressing the structural issues generating the deficits in the first place: expanding state governments that spend beyond their means. Before seeking new ways to extract resources from the private sector, states should re-examine existing programs to contain costs and eliminate waste.

Facing the Music: State Spending

An important option for reducing state deficits is to rein in spending. The major components of state spending include primary and secondary education, Medicaid, higher education, corrections, and public assistance. All of these programs should be reviewed to eliminate ineffective programs and streamline costly projects that drain state treasuries.

A number of concerns have been raised about education, for example. Large bureaucracies have been ineffective at providing a quality education in many instances. Alternative programs such as vouchers and school choice may introduce competition that can enhance the efficiency of educational programs while reducing burdens on the state government.

Medicaid, a program where outlays increase during an economic slowdown, should also be examined with an eye toward cost savings. The costs of the program, which serves over 40 million people, have been rising significantly. According to the National Center for Policy Analysis, Medicaid expenditures exceeded budgeted amounts in 37 states last year and the costs of providing prescription drugs increased at annual rate of more than 20 percent in most states. The Medicaid program is one of the largest budget items for most states and it is also a program that has been plagued with waste, fraud, and abuse. Administrative costs are high, and the third-party payer system underlying the program means that individual Medicaid recipients have no incentive to minimize the costs of the program. The program contains incentives that continue to push costs higher and many states are reluctant to reform the program because it does provide federal funding for the states. Clearly, in tight budgetary times, Medicaid reform cannot be overlooked. President Bush has proposed reforms that would allow states to keep any savings generated by the reforms. This would provide states an incentive to control costs of this expansive program.

While many states acknowledge the need to address excessive spending, few have pushed to systematically eliminate unnecessary government programs. The most common response to a spending problem is across-the-board cuts in state spending. While this may alleviate the current imbalance, it avoids the tougher examination of the merits of government spending. In essence, it assumes that all programs are beneficial, but all must share the burden of a spending cut. Yet not all spending programs are equal. Ineffective or redundant programs should be eliminated, not downsized. States must do more than simply cut spending across the board; poorly performing programs must be addressed in the process of establishing a budget.

Shedding Unnecessary Government Programs

In addition, a number of services offered by state governments may be provided just as effectively, if not more so, by private entities. Private entrepreneurs have demonstrated the ability to deliver everything from correctional facilities to private toll roads. Such opportunities should not be overlooked. Massachusetts, for example, has implemented a system of private highway maintenance that saved considerable resources, according to the Reason Public Policy Institute. One study found the private contractors to be over 20 percent more efficient that the state in maintenance services. Other states, such as Illinois, have moved forward with efforts to privatize correctional facilities.

Privatization provides an opportunity for state governments to reduce budgetary pressures while increasing efficiency at the same time. According to the Reason Public Policy Institute, more than half of the states intend to increase efforts at privatization over the next five years. Through asset sales, contract management, and other opportunities that allow the private sector to offer services previously provided by the government, states have the potential to save taxpayer dollars that should not be overlooked.

Saving for a Rainy Day

The rainy day fund is another option available to states, and already four states chose to spend down these funds to balance the budget in 2001 according to NASBO. While such set asides may help states address a sudden economic downturn, they also divert resources away from the private sector and allow states to avoid making important decisions about the viability of long run economic growth. If states accumulate too great a rainy day fund, this takes resources that could be more effectively used by taxpayers. At the same time, rainy day funds were not meant to cover systemic shortfalls in structural programs. These funds were not meant to paper over problems that are more effectively addressed by establishing spending priorities and maintaining fiscal discipline. While useful for addressing a short-term budgetary gap, rainy day funds should be limited in size and scope. They should not unnecessarily tie up resources better kept in the private sector, and they should not be used fund longer-term projects that have been under-funded in the state budget.

Florida: A Case Study in Fiscal Strategies

Struggling with a $1.3 budget shortfall, politicians in the Florida legislature are seeking new ways to address budgetary shortfalls. One approach is to broaden the tax base so future revenues will grow at faster rate, allowing the state government to play a larger and larger role in the economy. The alternative is to limit the growth of state government, much the way a family limits its spending.

Florida Senate Majority Leader John McKay has opted for the increased revenue strategy, claiming the Florida tax base is archaic and not suited to a modern economy. Despite the fact that the current tax structure has allowed state spending to keep pace with Florida’s population base and actually increase in real terms on a per capita basis, McKay seeks to expand revenue collections to include many services currently not taxed in the state.

Although the plan reduces some taxes to offset new taxes and is said not to increase taxes when it is enacted, the plan is clearly designed to increase revenues over time, allowing state spending to increase as a percentage of the overall state’s output. These increases are structural in nature, they do not disappear as the economy recovers. Rather than make hard choices about state spending priorities, this plan sets in motion a growing revenue base that ultimately takes more tax dollars from consumers and replaces private sector spending with government spending.

Florida Rep. Rob Wallace has proposed an alternative to a new tax base that would limit the growth of government not to exceed growth in the state as a whole. Wallace has proposed a constitutional amendment that would limit state spending to last year’s budget plus a growth adjustment based on the consumer price index and population growth. Government would be able to expand as the state grows, but it would not be able to grow any faster than its citizenry.

Putting such limitations on the growth of taxes and expenditures by the state is nothing new, but it is a tool that more states are considering. Since the tax revolts of the 1970s, 26 states have adopted some limit on taxes and spending, according to Michael New of the Cato Institute. New’s research found two strategies most successful for limiting the growth of government. First, limitations that restrict growth to the rate of inflation plus population growth—such as the Wallace proposal in Florida—are effective. Second, policies that refund taxpayers immediately for any excess collections made by the state can reduce the growth of government. Oregon provides a good example of immediately return excess revenue to taxpayers. Even though the state has a constitutionally mandated “kicker” that requires excess revenues to be returned, the current legislature has fought stridently to avoid returning such funds to the taxpayers, and ultimately the state managed to reduce the amount that was to be refunded.

Conclusion

When facing a fiscal crisis, states have many strategies available. The best limit the growth of government spending and avoid placing new tax burdens on consumers, especially in slow economic times. This requires a serious look at state spending in order to establish priorities, eliminate unnecessary or wasteful programs, and maintain spending levels previously established. With the end of the economic boom, states must choose between fiscal discipline or a search for new taxes. With economic performance down and the private sector competing for resources, states should avoid burdensome taxes and big government solutions. The best approach is to foster economic growth in the private sector and allowing businesses to expand and generate the jobs necessary to fuel economic growth.